Tax-exempt securities are investments that generate income exempt from federal, local, and sometimes state taxes. Usually, these are municipal bonds, obligations of states, territories, or municipalities. Interest acquired from U.S Savings Bonds may also be free from federal income taxes for selected investors. A major benefit to note is that income like interest and dividends from tax-exempt securities doesn't incur federal taxes. Depending on the investor's location, a tax-exempt security might be free from all taxes.
For instance, taking a hypothetical investor, John Smith who bought a $5,000 bond with a coupon rate of 3% from a local government that matures in two years. He would receive an interest income of $150 each year that isn't subject to federal or state taxes. Upon maturity, he gets his principal investment returned.
These tax exempt bonds also incentivize local governments and non-profit entities to kickstart new projects. The low interest rates mean a lower cost of borrowing. However, for investors, it's important to balance the lower yield with the tax savings the bonds provide.
In addition to looking into the tax treatment, examining other components like management fee and yield is equally vital when opting for tax-exempt mutual funds and ETFs. The higher an investor's marginal tax rate is, the more they'll benefit from tax-exempt securities. This can be further understood through the calculation of the tax-equivalent yield, which is often higher than the yield, based on the investor's tax bracket.
Notably, organizations typically have to be registered under section 501(c)(3) of the Internal Revenue Code (IRC) to issue tax-exempt securities. Example tax-exempt municipal bond funds include FMBIX, MUB, and VWAHX which can be purchased through an online brokerage or a full-service bank.
Even though tax-exempt securities can potentially free investors from federal, state, or local taxes, there are some states, like Illinois and Wisconsin, where the interest income on municipal bonds is taxable for their residents. Despite typically having lower yields compared to taxable securities, tax-exempt securities' low yield might be balanced with their tax treatment. This is particularly true for investors in higher tax brackets.